Approaches for Cost of Equity

•Risk
• Return
•Security Market Line
•CAPM
•CML
 Defining Risk

 Risk refers to the chance that some unfavorable

event will happen
 Investment risk is the probability that actual returns
may deviate from expected returns
 The chance that actual returns may be lower than
expected return gives rise to investment risk
 Higher the probability of actual returns being less
than expected, higher will be investment risk
 Returns

 Actual Return
 Realized return/historical return/return ex-post
 Expected Return
 Return ex-ante/anticipated return
 A weighted average of all possible returns, where
weights represent probability of each possible outcome
 Multiply each possible outcome with its probability and
add them up over all possible outcomes
 Factors Affecting Expected Return

 Time value of money – measured by the risk-

free rate
 Reward for bearing systematic risk –
measured by the market risk premium
 Amount of systematic risk – measured by
beta

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 Risk and return are always positively related
 Higher return is associated with high risk
 Portfolio Risk and Return

 Meaning of Portfolio
 A combined holding of more than one stock, bonds, real
estate, or any other asset
 Why create a portfolio?
 To diversify/reduce/mitigate risk of a single security
 All securities in the portfolio may not move together
 If one goes down, others will go up and compensate for
the loss of the first one
 Portfolio Risk

 Risk of a portfolio is measured by standard

deviation of the portfolio (p)
 Standard deviation of a portfolio is not a simple
weighted average of the standard deviations of each
individual security in the portfolio
 Theoretically, it is possible to combine two risky
securities and create a zero risk portfolio without
compromising returns.
 Portfolio Risk

 Total risk as measured by standard deviation does

not matter in a portfolio context
 Total risk can be divided into two categories

Total Risk = Unsystematic Risk + Systematic Risk

 In a well diversified portfolio, only systematic risk

matters; unsystematic risk disappears and is zero.
 Continued ……

Systematic Risk
Risk that influences a large number of assets, each to a greater
or lesser extent.
Also called Non-Diversifiable or Market Risk.
Examples: changes in GDP, inflation, interest rates, general
economic conditions

Unsystematic Risk
Risk that affects a single asset or a small group of assets.
Also called Diversifiable or unique or asset specific risk.
Includes such events as labor strikes, shortages.
 Portfolios Risk and Beta

 Systematic risk of a portfolio is measured by beta of

a security
 Meaning of beta
 Tendency of a stock to move with the market
 Sensitivity of an asset’s price to the changes in the
market
 Beta of a risk free security
 Beta of a market portfolio
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 Cost of Equity

 The cost of equity is the return required by equity

investors given the risk of the cash flows from the
firm
 Business risk
 Financial risk
 There are two major methods for determining the
cost of equity
 Dividend growth model
 SML, or CAPM
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 The Dividend Growth Model
Approach
 Dividend Growth Model

Dividend Yield Growth

D1/P0 ROE * Retention Rate

Where,
D1 = Dividend in year 1
Po = Price of stock at time 0
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ROE = Return on equity
 The Dividend Growth Model
Approach
 Start with the dividend growth model
formula and rearrange to solve for RE

D1
P0 
RE  g
D1
RE  g
P0
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 Example

Last year Dividend = 30

Next year Dividend = 40
P0 =400
ROE = 50%
Retention Ratio = 20%

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 Advantages and Disadvantages of
Dividend Growth Model
 Advantage – easy to understand and use
 Disadvantages
 Only applicable to companies currently paying
dividends
 Not applicable if dividends aren’t growing at a
reasonably constant rate
 Extremely sensitive to the estimated growth rate – an
increase in g of 1% increases the cost of equity by 1%
 Does not explicitly consider risk

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 Security Market Line

 Positive relationship between systematic risk

and return of a portfolio
 The line which gives the expected returns-
systematic risk combinations of assets is
called the security market line
 Security Market Line

 The security market line (SML) is the

representation of market equilibrium
 The slope of the SML is the reward-to-risk
ratio: (E(RM) – Rf) / M
 The beta for the market is always equal to
one, the slope can be rewritten
Slope = E(RM) – Rf = market risk premium

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 The Security Market Line (SML)

 The SML is the key contribution of the CAPM

to asset pricing theory
 The SML equation is:
E( Ri )  RF  E( RM )  RF i
 The SML represents the trade-off between
systematic (as measured by beta) and expected
returns for all assets
Security Market Line

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 Advantages and Disadvantages
of SML
 Advantages
 Explicitly adjusts for systematic risk
 Applicable to all companies, as long as we can estimate
beta
 Disadvantages
 Have to estimate the expected market risk premium,
which does vary over time
 Have to estimate beta, which also varies over time
 We are using the past to predict the future, which is not
always reliable
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 The Capital Asset Pricing Model
(CAPM)
 The capital asset pricing model defines the
relationship between risk and return

E(RA) = Rf + A(E(RM) – Rf)

 If we know an asset’s systematic risk, we

can use the CAPM to determine its
expected return

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The Capital Asset Pricing Model
(CAPM)
 Capital market theory is concerned with
equilibrium security prices and returns and
how they are related to the risk-expected
return trade-off that investors face
 It measures the relative risk of an
individual security and the relationship
between risk and the returns expected from
investing
 Example – Cost of Equity
 Suppose our company has a beta of 1.5. The market risk
premium is expected to be 9%, and the current risk-free
rate is 6%. We have used analysts’ estimates to
determine that the market believes our dividends will
grow at 6% per year and our last dividend was $2. Our
stock is currently selling for $15.65. What is our cost of
equity?
 Using SML: RE = 6% + 1.5(9%) = 19.5%
 Using DGM: RE = [2(1.06) / 15.65] + .06 =
19.55%
 When possible average the two methods
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 Assumptions of the CAPM
Investors are risk-averse, utility-maximizing, rational
individuals.
Markets are frictionless, including no transaction
costs or taxes.

Investors plan for the same single holding period.

Investors have homogeneous expectations or beliefs.

All investments are infinitely divisible.

Investors are price takers.

 Applications of the CAPM

Estimates
of Expected
Return

Security CAPM Performance

Applications Appraisal
Selection
 Limitations of the CAPM

• Single-factor model
Theoretical • Single-period model

• Market portfolio
• Proxy for a market portfolio
Practical • Estimation of beta
• Poor predictor of returns
• Homogeneity in investor expectations
 Capital Market Line (CML)

 Depicts the equilibrium conditions that

prevail in the market for efficient portfolios
consisting of the optimal portfolio of risk-
free and risky assets

 All combinations of assets are bound by the

CML and at equilibrium all investors end up
with efficient portfolios
 Capital Market Line (CML)

 Slope of the CML is the market price of risk for

efficient portfolios

E ( RM )  RF
 Slope of the CML =
M

 The CML is always upward sloping because the

price of risk is always positive
Capital Market Line (CML)

The CML and the Components of Its Slope